Chapter 19:

Share-Based Compensation
ASC 718 (SFAS 123R)

Learning Objectives
1. Accounting for stock award plans.
2. Accounting for stock options.
3. Accounting for employee share purchase plans.
4. Simple and a complex capital structure.

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 Share-Based Compensation
Form of compensation in which the amount of the
compensation employees receive is tied to the
market price of company stock.
An executive compensation plan is tied
to performance in a strategy that uses
compensation to motivate it recipients.

These share-based compensation plans

–stock awards,
-stock options, and
-stock appreciation rights,
create shareholders’ equity.
The nature of this compensation will impact
the way earnings per share is calculated.
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 Share-Based Compensation

Whichever form such a plan assumes, the

accounting objective is to record the fair value
of compensation expense over the periods in
which related services are performed.

This requires:

1. Determining the fair value of the compensation.

2. Expensing that compensation over the

periods in which participants perform services.

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 Stock Award Plans
FEATURES:

The compensation is a grant of shares of stock.

-The shares usually are restricted (non-vested) so that

benefits are tied to continued employment.

-Usually shares are subject to forfeiture if employment is

terminated within some specified number of years from the
date of grant.

-The employee cannot sell the shares during the restriction

period. => Between GRANT Date and VESTING Date.

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 Stock Award Plans

Compensation is a grant of shares of stock….

-The compensation is simply the market price of the stock

at the grant date.
-Compensation is accrued as expense over the service
period for which participants receive the shares.
-The service period usually is the period from the date of
grant to when restrictions are lifted (the vesting date).
-If restricted stock is forfeited, related entries previously
made would simply be reversed.

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 STOCK AWARD PLANS ILLUSTRATION
Under its restricted stock award plan, Universal Communications grants
5 million of its $1 par common shares to certain key executives at
January 1, 2011. The shares are subject to forfeiture if employment is
terminated within 4 years. Shares have a current price of $12 per share.

January 1, 2011
No entry

Calculate total compensation expense:

$12 Fair value per share
x 5 million Shares awarded
= $60 million Total compensation

The total compensation is allocated to expense over the 4-year service

(vesting) period: 2011 – 2014 as follows:

$60 million ÷ 4 years = $15 million per year

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 STOCK AWARD PLANS ILLUSTRATION

Journal Entries:
December 31, 2011, 2012, 2013, 2014 ($ in millions):
Compensation expense ($60 million ÷ 4 years) 15
Paid-in capital – restricted stock 15

December 31, 2014 (On Vesting Date):

Paid-in capital– restricted stock (5 million sh. at $12) 60
Common stock (5 million shares at $1 par) 5
Paid-in capital – excess of par (to balance) 55

If restricted stock is forfeited because, say, the employee quits the
company, related entries previously made would simply be reversed.

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 STOCK AWARD PLANS

Exercise 19-1
Exercise 19-2
Exercise 19-4

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 Stock Option Plans
Stock option plans give employees the option to buy
(a) a specified number of shares of the firm's stock,
(b) at a specified exercise price,
(c) during a specified period of time.

The fair value is accrued as compensation expense

over the service period for which participants receive
the options, usually from the date of grant to when
the options become exercisable (the vesting date).

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 Expense – The Great Debate
Historically, options have been measured at
their intrinsic value – the simple difference
between the market price of the shares and
the option price at which they can be
acquired.
If the market and exercise price are equal on
the date of grant, no compensation expense
is recognized even if the options provide
executives with substantial income.

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 Failed Attempt to Require Expensing
Opposition to a proposed FASB Statement to
recognize expense for certain stock option
plans have identified three objections.
1. Options with no intrinsic value at issue
have zero fair value and should not give
rise to expense recognition.
2. It is impossible to measure the fair value
of compensation on the date of grant.
3. Current practices have unacceptable
economic consequences.

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 Recognizing Fair Value of Options

Accounting for stock options parallels the accounting

for restricted stock we discussed earlier.
We now are required to estimate the fair value of
stock option on the grant date.

The FASB now requires that compensation expense be

measured using one of several option pricing models
that deal with:
1. Exercise price of the option.
2. Expected term of the option.
3. Current market price of the stock.
4. Expected dividends.
5. Expected risk-free rate of return.
6. Expected volatility of the stock.
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 EXPENSING STOCK OPTIONS
At January 1, 2011, Universal Communications grants
options that permit key executives to acquire 10 million of
the company’s $1 par common shares within the next 8
years, but not before December 31, 2014 (the vesting
date). The exercise price is the market price of the
shares on the date of grant, $35 per share. The fair value
of the options, estimated by an appropriate option-pricing
model, is $8 per option.
January 1, 2011
No entry
Calculate total compensation expense:
$8 estimated fair value per option
x 10 million options granted
= $80 million total compensation

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 EXPENSING STOCK OPTIONS

At January 1, 2011, Universal Communications grants options that permit

key executives to acquire 10 million of the company’s $1 par common shares
within the next 8 years, but not before December 31, 2014 (the vesting date).
The exercise price is the market price of the shares on the date of grant, $35
per share. The fair value of the options, estimated by an appropriate option-
pricing model, is $8 per option.

The total compensation is allocated to expense over the 4-year service

(vesting) period: 2011 - 2014
$80 million ÷ 4 years = $20 million per year

December 31, 2011, 2012, 2013, 2014 ($ in millions)

Compensation expense ($80 million ÷ 4 years) 20
Paid-in capital – stock options 20

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 EXPENSING STOCK OPTIONS
ESTIMATED FORFEITURES
 If a forfeiture rate of 5% was expected, annual compensation
expense would have been $19 million ($76 / 4) instead of $20
million.

 During 2013, the third year, Universal revises its estimate of

forfeitures from 5% to 10%. The new estimate of total
compensation would then be $80 million x 90%, or $72 million.

 The expense each year is the current estimate of total

compensation that should have been recorded to date
less the amount already recorded.
3rd Year = $16M = ($80 million x 90% x ¾) – [$19 + 19])
4th Year = $18M = ([$80 million x 90% x 4/4] – [$19 + 19 + 16])

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 EXPENSING STOCK OPTIONS

ESTIMATED FORFEITURES

2011 ($ in millions)
Compensation expense ($80 x 95% x 1/4) 19
Paid-in capital –stock options 19
2012
Compensation expense ($80 x 95% x 1/4) 19
Paid-in capital –stock options 19
2013
Compensation expense ([$80 x 90% x ¾] – [$19 + 19]) 16
Paid-in capital –stock options 16
2014
Compensation expense ([$80 x 90% x 4/4] – [$19 + 19 + 16]) 18
Paid-in capital –stock options 18

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 EXPENSING STOCK OPTIONS
WHEN OPTIONS ARE EXERCISED
If half the options (five million shares) are exercised on July 11, 2014,
when the market price is $50 per share, the following journal entry is made:

July 11, 2014 ($ in millions)

Cash ($35 exercise price x 5 million shares) 175
Paid-in capital - stock options (1/2 account balance) 40
Common stock (5 million shares at $1 par per share) 5
Paid-in capital – excess of par (to balance) 210

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 STOCK OPTIONS

Exercise 19-5
Exercise 19-6
Exercise 19-8

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 EXPENSING STOCK OPTIONS

WHEN VESTED OPTIONS EXPIRE WITHOUT BEING EXERCISED

If options that have vested expire without being exercised, the following
journal entry is made (assuming none of the options were exercised):

($ in millions)
Paid-in capital – stock options (account balance) 80
Paid-in capital – expiration of stock options 80

Exercise 19-7(#5)
BE 19-2 & 5

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 EXPENSING STOCK OPTIONS
PLANS WITH PERFORMANCE OR MARKET CONDITIONS
The way we account for such plans depends on whether the condition is
performance-based or market-based.

Performance Target Example:

An option may not be exercisable until a performance target is met.
The target could be:
-Divisional revenue,
-Earnings per share,
-Sales growth or
-ROA.

Market-related Targets:
-A specified stock price;
-A stock price change exceeding a particular index;

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 EXPENSING STOCK OPTIONS
Plans with Performance Conditions
If compensation from a stock option depends on meeting a performance target,
then whether we record compensation depends on whether or not we feel
it’s probable the target will be met.
If the initial expectation is that it is not probable that the target will be met,
we record no annual compensation expense.
2011:
NO ENTRY

2012:
NO ENTRY

If, after two years, the expectation is that it is probable that the target will be
met, we record the cumulative effect on compensation in 2013 earnings and
record compensation thereafter:
2013 BE 19-6,
Compensation expense ([$80 x ¾] - $0) 60
BE 19-7,
Paid-in capital –stock options 60
2014 BE 19-8
Compensation expense ([$80 x 4/4] - $60) 20
Paid-in capital –stock options 20
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 EXPENSING STOCK OPTIONS
Plans with Market Conditions
If the award contains a market condition (e.g., a stock
option with an exercisability requirement based on the
stock price reaching a specified level), then we
recognize compensation expense regardless of
when, if ever, the market condition is met.

Meaning, no special accounting is required!!

REASON:
The fair value estimate of the stock options based on
Option Pricing Models already incorporated market
conditions.
BE 19-9
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 Plans With Graded-Vesting
Rather than stock option plans vesting on a single date, more plans
awards specify that recipients gradually become eligible to exercise
their options rather than all at once. This is called “graded vesting.”
Accounting for compensation expense may be handled:
1 2
The company may estimate a The company may use a slightly more
single fair value for each of the complex method because it usually results
options, even though they vest in lower expense. In this approach, we view
over different time periods, each vesting group separately, as if it
using a single weighted- were a separate award.
average expected life of the
options. For example, a company may award
stock options that vest 25% in the first
year, 25% in second year, and 50% the
third years.

For accounting purposes we have three

separate awards.
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 Plans With Graded-Vesting

Illustration 19-3
(Page 1078)
Graded vesting

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 U.S. GAAP vs. IFRS
There are more similarities than differences in the treatment of stock
options. One major difference is the treatment of deferred tax assets
and when options have graded-vesting.

• Account for each vesting • Straight-line choice is not

amount separately or account permitted. Companies not
for the entire award on the required to recognize the award
straight-line basis over the that has vested by each reporting
entire vesting period. date.

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 Employee Share Purchase Plans
Permit employees to buy shares directly from
their employer.
Usually the plan is considered compensatory,
and compensation expense is recorded.
Employees may buy 100 shares of no par stock
for $8.50 per share. The current market price is
$10.00. The $1.50 discount is recorded as
compensation expense:

Cash (100 × $8.50) 850

Compensation expense (100 × $1.50) 150
Common stock (100 × $10.00) 1,000
Market value
Exercise 19-9
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 Tax Implications
 For tax purposes, plans can either qualify as an “incentive stock
option plan” (qualified) under the Tax Code or be "unqualified
plans."

 Among the requirements of a qualified option plan is that the

exercise price be equal to the market price at the grant date.
Under a qualified incentive plan:
-The recipient pays no income tax until any shares acquired are
subsequently sold.
-On the other hand, the company gets no tax deduction at all.

With a non-qualified plan:

-the employee can’t delay paying income tax, and
-the employer is permitted to deduct the difference between
the exercise price and the market price at the exercise date.

Example: Page 190: Additional Consideration: Tax Consequences….

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 U.S. GAAP vs. IFRS
There are more similarities than differences in the treatment of stock
options. One major difference is the treatment of deferred tax assets
and when options have graded-vesting.

• A deferred tax asset (DTA) is • The deferred tax asset is not

created for the cumulative created until the award is “in
amount of the fair value of the the money;” that is it has intrinsic
options the company has value.
recorded for compensation
expense.

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 Home Work

Problem 19-1
Problem 19-2
Problem 19-3

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 Part B: Earnings Per Share
I. For analysts and the financial press, earnings per share is the most
frequently cited and reported measure of a company’s performance.
A. EPS is reported in the income statement of all publicly
traded firms.

B. In general, EPS is simply earnings available to common

shareholders divided by the weighted average number of
common shares outstanding.

II. If a company has no “potential common shares” we consider

it to have a simple capital structure.
A. For a simple capital structure, a single presentation
of basic EPS is sufficient.
B. If there are no securities other than common stock and
the number of common shares remained unchanged, basic
EPS is simply net income divided by common shares.
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EARNINGS AVAILABLE TO COMMON SHAREHOLDERS
Preferred dividends are subtracted from net income so that
“earnings available to common shareholders” is divided by
the weighted average number of common shares.
EXAMPLE:
Sovran Financial Corporation reported net income of $154
million in 2011 (tax rate 40%).
Its capital structure included:
Common stock
January 1 60 million common shares were outstanding
March 1 12 million new shares were sold
June 17 A 10% stock dividend was distributed
October 1 8 million shares were reacquired as treasury stock

Preferred stock, nonconvertible

January 1 5 million 8%, $10 par, shares outstanding
 EARNINGS AVAILABLE TO COMMON SHAREHOLDERS

Basic EPS:
(amounts in millions, except per share amount)

net preferred
income dividends
$154 – $4 * = $150 = $2
60(1.10) + 12 (10/12)(1.10) – 8 (3/12) = 75
Shares new treasury
at Jan. 1 shares shares
_____stock dividend_______
adjustment

•5,000,000 x $10 x 8% = $4

EXERCISE 19-14
 Diluted Earnings Per Share
When a company has securities that could potentially
Dilute (i.e., reduce) earnings per share, it is classified as a
complex capital structure.
These potential common shares include stock options
And Convertible securities.
The company reports both basic and diluted earnings per
share.
For diluted EPS, the impact of each potentially dilutive
security is reflected by calculating earnings per share
as if the security already had been exercised or converted
into additional common shares.

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 Diluted Earnings Per Share

Potential Common Shares: Complex Capital Structure

(dual EPS)
•Stock options, rights, and
warrants
•Convertible bonds and stock
Stock Convertible
•Contingent common stock
Options securities
issues

Contingently Treasury If-converted

issuable stock method method
shares

Dilution/Antidilution Test

May Report Basic EPS and Diluted EPS

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 Options, Rights, and Warrants

The treasury stock method

assumes that proceeds Proceeds
from the exercise of options
are used to purchase At
treasury shares. average Used to
market
This method usually results
price
in a net increase in shares
included in the denominator Purchase
of the calculation of diluted treasury
earnings per share. shares

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 Options, Rights, and Warrants
1. Determine new shares from assumed exercise of stock options

Proceeds from assumed exercise

Average-of-period market price of stock

2. Compute shares purchased from the treasury.

3. Compute the incremental shares assumed outstanding:

New shares from assumed exercise (1)

Less: Treasury shares assumed purchased (2)
= Net increase in shares outstanding (3)

Illustration 19-9 (Page 202): Stock Options

Exercise 19-15 & 19-16
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 Options, Rights, and Warrants

When the exercise price

exceeds the market price,
the securities are antidilutive
and are excluded from the
calculation of diluted EPS.

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 Convertible Securities

The if-converted method is used for

Convertible debt and equity
securities.
The method assumes conversion occurs
as of the beginning of the period or date
of issuance, if later.

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 Restricted Stock Awards
Restricted stock awards are quickly replacing
stock options as the share-based compensation
plan of choice. Like stock options, the treasury
stock method is used to calculate the number of
shares in the denominator of the EPS equation.
Unlike stock option, employees do not pay to
acquire their shares of stock.

No adjustment to the numerator

Denominator is increased using treasury method

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 Summary

Dilutive Effect Shown?

Potential Common Shares Basic EPS Diluted EPS
Stock options (or warrants, rights) no yes
Restricted stock awards no yes
Convertible securities (bonds, notes,
preferred stock) no yes
Contingently issuable shares no yes

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 Summary
Modification to EPS Equation
Potential Common Shares Numerator Denominator
Add incremental
Stock options (or warrants, rights) None
shares
Add shares created
by vesting, reduced
Restricted stock award None by repurchased
shares at the
average stock price
Add shares
Add after tax
Convertible bonds or notes issuable upon
interest
conversion
Add shares
Add back dividends
Convertible preferred issuable upon
declared
conversion
Contingently issuable shares
Add shares
Conditions being currently met None
issuable
Conditions not being met None None

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 Financial Statement Presentation
Report EPS data separately for:
1. Income from Continuing Operations
2. Separately Reported Items
a) Discontinued Operations
b) Extraordinary Items
3. Net Income

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 Appendix 19A – Option-Pricing Theory
Intrinsic value is the benefit the holder of an
option would realize by exercising the option
rather than buying the underlying stock directly.
An option that permits an employee to buy $25
stock for $10, has an intrinsic value of $15.

Options have a time

value because the
holder of an option does
not have to pay the
exercise price until the
option is exercised.
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 Summary
The fair value of an option is (a) its intrinsic value plus (b)
its time value of money plus (c) its volatility component.

All Other Factors Being Equal, If the: The Option Value Will Be:
Exercise price is higher Lower
Term of the option is longer Higher
Market price of the stock is higher Higher
Dividends are higher Lower
Risk-free rate of return is higher Higher
Volatility of the stock is higher Higher

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 Appendix 19B - Stock Appreciation Rights
• A. SARs enable an executive to benefit by the amount
that the market price of the company’s stock rises,
but without having to buy shares.

• B. The executive receives the “share appreciation” at

exercise that has occurred since the date of grant.

• C. Share appreciation is the increase in the market

price over a pre-specified price (usually the market price
at the date of grant).

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 Appendix 19B - Stock Appreciation Rights

 The SARs are considered to be equity if the

employer can elect to settle in shares of stock.
 The amount of compensation is estimated at
the grant date as the fair value of the SARs.

Usually the same as the fair

value of a stock option with
similar terms.
 This amount is expensed over the service
period.

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 Stock Appreciation Rights
 The SARs are considered to be a liability if the
employee can elect to receive cash upon settlement.
In that case, the amount of compensation (and
related liability) is estimated each period and
continuously adjusted to reflect changes in the fair
value of the SARs until the compensation is finally
paid.

 The current expense (and adjustment to the liability)

is the fraction of the total compensation earned to
date by recipients of the SARs (based on the
elapsed percentage of the service period), reduced
by any amounts expensed in prior periods.

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End of Chapter 19